Check that your financial ducks are in a row

No penalties: you might think you have a lump sum ready to invest, but first check you have other expenses covered, and most importantly that you have a contingency fund that would keep you going for three to six months or longer

A reader asks: “I have $40,000 sitting in a local bank account, just doing nothing. Can you advise on best investment options to yield a higher rate?”

Choices, choices. The easiest answer would be to simply say why not consider a mutual fund with a total return average over the last few years of 6.5 per cent, or a local stock with a dividend of 4.1 per cent? Heck, I wouldn’t even have to write an article, I could just encourage the reader to visit local financial institutions.

What was your first thought when you read the question? What would be your answer? Wouldn’t you like to know a bit more about this person? And what should we know about this individual before we recommend anything?

At first glance, we don’t know if the inquiry is from a woman or a man. We don’t know their age or what they do for a living, what they own and what are their liabilities, how much they earn, and how they think about the risk of investing.

We do have a bit more information. The reader is 50 and wants to grow the amount for their retirement. That’s helpful, but not enough for us to provide the fiduciary standard of investment advice where the client’s best interests are served first and foremost.

Instead, what we will do is explore alternatives rather than spouting a rigid financial planning strategy. We can make assumptions and suggest various investment scenarios that will allow the reader to pick the best choice for their circumstances.

Here are the first, basic questions for our reader; the ones that I always ask.

The investment decision is last, and only when I’m assured that the person’s current finances are in balance and the client is amenable to this scrutiny.

What does “in balance” mean? And are your financial ducks all in a row? To find out, give a yes or no answer to each of the following questions.

1. Do you have additional savings that are readily available, above and beyond this $40,000? Do not count your pension, since it is not liquid.

2. To the best of your knowledge is your job secure? If not, what is your fallback position?

3a. Do you have a mortgage?

3b. Are you a renter (tenant)?

4. In the near future do you plan to purchase a large asset, such as a house or car?

5. Do you have any other immediate liabilities, such as credit cards, loans or relocation expenses, that need to be paid?

6. After paying living expenses do you have spare income to save at the end of each month?

7. Do you have other family responsibilities, such as children, eldercare, alimony, or child support?

8. If so, do you have any life insurance?

9. Do you have a pension from your employer(s)?

10. Do you have a basic understanding of investment products?

11. Are you uncomfortable when capital market values are fluctuating dramatically, such as a sustained drop in value of 10 per cent or more?

12. If No. 7 applies to you, do you have a will?

Questions 1 and 2 are critical if you answered no. Here is why.

We live in uncertain times, therefore it is very important that you create a cash buffer to tide you over when finances become tight. We know that those situations can happen at any time. There could be unexpected redundancy, serious illnesses, family emergencies, accidents, and so on.

The cash buffer must be readily available. The old rule of three to six months living expenses is acceptable, a year of living expenses is better; two years or more if you are retired or close to.

If the reader who posed the enquiry at the start of this article answered “no” to those first two questions in the list, then investing that $40,000 for a higher capital market return is not recommended.

Imagine the devastation if all $40,000 was fully invested, and then the capital markets’ volatility ramped up and valuations tanked way below what they were when invested. Or, in a worst-case scenario, the investments cannot be redeemed in a speedy fashion

Yes, these situations do happen to many small investors. My general advice is to keep saving fiercely until you meet your personal buffer number, then you can and should consider investing for long-term appreciation.

Now, question 3a is a debatable topic. If we assume that our reader has a mortgage and other savings, then I would encourage using the $40,000 as a complete mortgage principal reduction. Readers will argue that this is not investing, but I disagree. You are saving the cost of the interest (6 to 8 per cent, or more, in Bermuda) every time you prepay the principal.

Regarding questions 3b, 4, 5, 6, 7, 8, renting, purchases, and current liabilities such as credit cards, all focus on having sufficient available in cash to lease a residence, reduce debt to bare minimum and save for a house of your own. Saving for a vehicle or home purchase, or preparing for contingencies in 7 and 8, again means keeping and growing your readily available cash buffer.

The goal to invest to get that better return becomes far more comfortable when you know that you have covered, as best you can, life contingencies that will demand immediate cash.

So, to summarise, plan first to fund your contingencies. That means an ample cash buffer, debt paydown, life insurance, and large purchases.

This more cautious advice is not unusual. Some clients reject the conservative position feeling that their cash is still better off earning more in capital markets. Readers should understand that it is their personal choice whether or not to take on some investment risk. All we can do as advisers is present the alternatives, the risks and the rewards, then it is up to you to decide what will work best for you.

Next week we will look at questions 9 to 12. We assume our reader has all their ducks in a row and as we discuss investments that might be suitable for them.

Martha Harris Myron CPA CFP JSM: Masters of Law — international tax and financial services. Pondstraddler Life, financial perspectives for Bermuda islanders with multinational families and international connections on the Great Atlantic Pond. Contact: martha@pondstraddler.com

Check that your financial ducks are in a row

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